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June 11, 2014

PCAOB adopts standard to prevent Enron-style frauds

The Public Company Accounting Oversight Board (PCAOB) has adopted a standard aimed at preventing a common potential source of fraud, transactions with the company’s related parties, which partly contributed to cause Enron’s accounting scandal.

The PCAOB’s Auditing Standard No. 18 Related Parties reinforces an interim standard which tackles the auditor’s duties to examine the deals a reporting company may have signed with a party with whom it has a special relationship.

Transactions with related parties are typically deals with persons or entities that have control, influence or somehow relate to the audited company, representing usually a conflict of interests.

These sorts of transactions, through the abuse of especial-purpose entities, were partly responsible for the Enron’s financial reporting misconduct, which led to the fall of its auditor, the former Big Five firm Arthur Andersen.

One of the duties Andersen didn’t fulfil was precisely failing to bring to the attention of Enron’s board concerns about related-party transactions, as Enron’s Special Investigation Committee report stated.

The PCAOB has also introduced procedural improvements to other auditing standards regarding two core issues: significant unusual transactions and financial relationship and transactions with executive officers.

As PCAOB chairman James Doty remarked, related party transactions and significant transactions that are outside the course of business, have historically represented a "contributing factor" in several financial reporting frauds.

Risk-based approachThe ultimate goal of the standard and the amendments, according to Doty, is protect investors from the risk of being misled by poor explanations and disclosures regarding these critical issues.

"Auditors ought to be highly focused on risks related to related party transactions, and many are. But our inspections have found that others miss opportunities to do so, by approaching existing requirements in a mechanistic way and failing to probe opaque or incomplete disclosures," Doty said yesterday at the PCAOB open meeting.

Doty added that the standard and amendments don’t involve introducing new software or complex procedures but rather focusing on approaching such transactions with a risk-based approach and scepticism.

PCAOB member Lewis Ferguson said the new standard now clearly states that management should be the initial source of the auditor to identify related party transactions, hence reflecting management’s responsibility for financial statements and disclosures.

Ferguson explained the standard complements other two, No.16 Communications with Audit Committees and No.12 Identifying and Assessing Risks of Material Misstatement.

In relation to the first one, it will require from the auditor to engage with the audit committee if the auditor finds out that a related party relationship or transaction hasn’t been disclosed. This will aid the audit committee’s oversight function, according to Ferguson.

In relation to the second one, through the performance of risk assessment procedures, the auditor should understand the company’s related transactions that might bear the risk of material misstatements in the financial statements.

Emerging Growth CompaniesIf approved by the Securities and Exchange Commission (SEC), the standard will be effective for audits of fiscal year beginning 15 December 2014.

The SEC should also decide if the standard is applicable to the audits of the so-called emerging growth companies (EGC).

As defined by the US law, a company registered with the SEC qualifies as an EGC if it had total annual gross revenues of less than $1bn in the previous fiscal year, among other requirements.

Commenting on the new standard the Center for Audit Quality (CAQ) executive director Cindy Fornelli, who welcomed the standard, said:

"The CAQ believes that the final standard and amendments should be applicable to the audits of Emerging Growth Companies. This will avoid bifurcation of the rules applied to financial statement audits performed in accordance with PCAOB standards, which could be confusing to investors and other stakeholders."

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